The stock market is not the economy. Here’s why

woman holding smartphone showing a graph representing a fall in the stock market

According to the latest Office for National Statistics (ONS) figures, UK GDP fell by 0.3% in the three months to October 2022 compared with the three months to July 2022.

The BBC reports that the Office for Budget Responsibility (OBR) say the UK economy is now in recession, and that this is likely to last until 2024. Indeed, the OBR say the UK economy will shrink by 1.4% in 2023.

A recession occurs when a country’s economy shrinks rather than grows. Typically spending falls, profits shrink, and unemployment rises. It’s also commonly associated with market downturns that, if severe, can become so-called “bear markets”, which is when stock markets decline by 20% or more from their previous peak.

While the economic outlook is bleak, a recession doesn’t necessarily mean losses for investors. At times like this it’s useful to remember the adage that “the stock market is not the economy”. Here’s why.

Markets often “price in” economic uncertainty

The first important issue to consider is that recessions and stock markets don’t move in tandem.

Stock markets often “price in” uncertainty or future expectations, and so the volatile markets of the last few months have partly resulted from the anticipation that a recession – and so falling profits – may be on the way.

Stock markets often fall in advance of the actual recession. Similarly, markets also tend to recover ahead of recessions being formally over.

Financial markets often respond to events quicker than the time it takes economic data to come through. So, uncertain markets in 2022 have already priced in the expectation of recession.

Stock markets do not reflect the wider economy

It’s also instructive to note that the makeup of the stock market does not reflect the wider economy. The giant companies that make up the FTSE 100 or S&P 500 operate under very different circumstances than small businesses.

FTSE 100 or S&P 500 companies make huge profits, hold significant sums of cash and are far more global than the typical family business. Schroders report that almost three-quarters (71%) of revenues generated by FTSE 100 companies come from outside the UK.

Often, the fact that local, small businesses may be struggling and laying off workers is relatively immaterial to the stock market. As long as redundancies don’t lead to a ripple effect, where broader economic issues affect their profitability, the stock market can continue to generate significant profits even if your local café or independent retailer has closed.

Recessions aren’t all the same

It’s also worth bearing in mind that not all recessions are the same. For example, Vanguard report that the US recession that occurred in the wake of the global financial crisis of 2007/8 lasted 18 months. The US economic collapse triggered by the Covid-19 pandemic, which was sharper, lasted just two months.

Remember also that recessions affect different parts of the world economy differently.

For example, while developed western economies shrunk in the aftermath of the global financial crisis, China’s economy performed much better, helping to partially offset the fallout.

This is why it’s so important to diversify your portfolio, as falls in one part of the economy can be offset by rises in another. You only have to look at the performance of various regional stock indices in 2022 to see this in action.

The table below shows the performance in various geographic indices in the year to 30 November 2022.

Source: JP Morgan

As you will see, gains in Japan and the UK in 2022 will have helped to offset losses made in Europe, the US, or Asia.

Markets will ebb and flow over time

As we enter another recession, it can be hard to hear but it’s a good reminder that stock markets ebb and flow. Over any period of long-term investing, it’s likely that there will be good and bad days, weeks, and even months.

History tells us, however, that periods of volatility and falling values typically last a lot less time than periods where markets are rising.

Source: Vanguard. Vanguard calculations, based on data from Bloomberg using the MSCI All-Country World Index from 31 December 1987 to 30 June 2022. Percentage monthly data on a total-return basis, with dividends reinvested, GBP terms.

This shows that the average length of a “bear market” – where values are falling – is around a year and a half. The average length of a bull market – when values are rising – is more than seven years.

Over a long-term investing horizon there will be blips. However, markets tend to tend towards growth and so being patient and riding out uncertainty by retaining a well-diversified portfolio aligned with your tolerance for risk is often the most sensible strategy.

Get in touch

If you’re concerned about the general economic climate, or you want to review your plans in light of the recession, please get in touch. Email or call us on 01454 416653.

Please note

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

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